Telecommunication Versus Processing Cost and The Consolidation of the Payment System

Diana HancockDavid B. HumphreyJames A. Wilcox

The advent of nationwide banking raises
the issue of whether consolidation of back-office operations reduces total costs.
Whether centralized or distributed processing of payments will be most cost efficient will
depend on the size and range of scale economies and on the costs of inputs like
telecommunications services and data processing. Though consolidating operations
into fewer sites may reduce costs as economies of scale are achieved, those cost savings
may be more than offset by the associated increases in telecommunications costs.

We use the experience of the Federal Reserve
in consolidating its Fedwire electronic payments operations form 1979 through 1996 to
estimate the extent of payments processing scale economies, technical change, and input
substitution in the face of substantial changes in relative input costs. Previous
research based on cross-sectional or panel data extending over five years suggested both
that the potential for realizing scale economies in Fedwire processing were minimal and
that observed declines in average Fedwire costs were largely attributable to technical
advance.

Our estimates suggest more nearly the
opposite: We estimated that Fedwire has experienced large scale economies, but that
the average amount of technical change was very small. One possible reason for the
difference is that we used 18 years of time-series and panel data. Another possible
reason is that our data processing and telecommunications input prices were already
adjusted for embodied technical change. Thus, we attribute technical change not to
the production function that produces Fedwire output, but rather to the production
function that produces the intermediate inputs used to produce Fedwire transfers.